Mirage of Inflation in the US economy

Ever since Fed started Quantitative Easing (QE) post Global Financial Crisis (GFC), there has been persistent talk of inflation bogey coming back to haunt the global economy. Now the bogeyman is back again to haunt us all. With the US Consumer Price Index (CPI) raising at a 4.2% vis-a-vis last year in the month of April, inflation in April accelerated at its fastest pace in more than 12 years as the U.S. economic recovery kicked into gear and energy prices jumped higher.

A myriad of economists, policy makers, policy suggesters and whole range of folks who show up on business news channels like CNBC are quantifying the implications of higher inflation. The fear is that decades of QE which has resulted in Fed’s balance sheet ballooning from ~$2 trillion in 2010 to ~$10 trillion now will come back to haunt the US economy with runaway inflation similar to the 1970s and 80s. Is the higher than expected April inflation numbers a precursor to the same ??

That is the question that everyone is talking about. And it is an important question, Trillions of dollars of investment will be decided basis whether there will be a sustained uptick in inflation or not? Should portfolios rejig to have a higher exposure to Gold and other commodities to hedge inflation? Is Bitcoin and other crypto currencies an asset class which can be leveraged as inflation hedging instrument? And more importantly and fundamentally, inflation rate will decide when and how will the Fed step back from QE and also start raising the interest rates. Any reduction in QE or increase in benchmark interest rates will lead to significant correction across asset classes including stocks, bonds and others. Hence the myriad discussions and debate on US inflation continues.

On the other had, this time Fed seems to be very less perturbed by the higher than expected inflation. Fed thinks that the current spate of high inflation is transitory majorly induced by the disruptions caused by Covid-19 pandemic. Fed hawks have chimed in over recent weeks to say that inflation is unlikely to get out of control despite unprecedented government spending in response to the coronavirus pandemic. Both Fed Chairman Jerome Powell and a top Biden administration economic adviser have said that the inflation now apparent in certain pockets of the economy is “transitory.”

And I tend to agree with the Fed here with regards to US inflation. The truth is that over the last decade, I was also initially intrigued by the arguments put forth by the hyper-inflationists on the impact of QE and how it should end result in higher inflation. But today, I have a more nuanced view of the same and here is why I think that Inflation is not yet for reckoning in the US.

Inflation as text book defines is the measure of rate of increase in price of basket of goods and services. Primarily it is caused by change in the Demand-Supply equilibrium. Hence for the inflation to occur, there are two scenarios

1. Supply : Inflation can be caused when there is not enough supply to match the Demand. This can be caused by either a sudden spurt in Demand which was not planned like in the case of increase in commodity prices between 2000 to 2011 where the rapid industrialisation of China and to a lesser extent the rest of BRICS resulted in rapid increase in price of major commodities. The other way a supply led inflation could result is where the supply is actually destroyed or reduced, like in case of a major war, natural disaster where the actual production capacity is destroyed or like in the more famous example of the oil embargo by OPEC on US where supply of oil was artificially constricted.
2. Demand: The more likely cause of inflation in majority of cases is the increase in Demand. This is typically result of a monetary or fiscal expansionary policy by the central bank or the government of its time. While there are many examples including Venezuela, Argentina and recently Turkey which fit the bill. A more at home example would be the regime under UPA-I & II in India whose policies led to runaway inflation.

Now coming to why I agree with the Fed over the hyper-inflationists with regards to the US inflation is this. The current increase in prices is primarily a supply driven hit. There has been shortage of materials, services and goods due to disruption caused by the pandemic which is resulting in shortages and hence higher prices. The prime example of the same is the chip shortage faced by global economy. Now it is easy to see that a major part of these shortages are short term in nature. There has been no permanent loss of production capacity. No factories, workshops or machines were destroyed, it is just that they were temporally closed.

The current cause of shortage is due to bull whip impact which has been magnified by the Just in Time supply chain processes followed globally. Additionally Covid-19 lockdowns and work from home environment has created an imbalance in the nature of demand for goods and services. Given the lack of availability and accessibility of services in a safe manner (Travel, entertainment, leisure, food, etc), there has been shift in consumption towards material goods such as home improvement tools, fitness equipments, etc. Therefore a dollar of spending has shifted from services to material goods increasing the shortage for the same. However, with the vaccination coverage increasing, there should be a reverse shift in spending has a lot of pent up demand for these services will get consumed in the coming days. This would mean lesser spend on material goods and more spend on services. Hence though there is a shortage today, it is not going to be a permanent structural shortage which can drive persistent high inflation.

Now the argument put forth by hyper-inflationists is with regards to QE and its impact on Demand. The truth is Fed is not printing trillions of dollars, what it has done is purchase assets from financial institutions. These has not created money in the hands of ordinary US citizens. Most of the additional reserves created by Feb for these institutions are parked again in Fed itself. Instead of causing a demand led inflation, QE has created a inflation in asset value itself as evidenced by the record high stocks. Every major asset class has since huge increase in its value with the poster child of the same being crypto currencies led by Bitcoin whose asset value has increased in multiples of 100s.

However, I repeat QE has not led to dollars in ordinary consumers hand and unless the same occurs, it will be very difficult to induce wage and material inflation. People do note that the stimulus checks is equivalent to handing people money, but it is important to note that the stimulus checks are temporary spends which in fact has helped the US economy from going to a deflationary spiral from the pandemic. Only if US congress constitutes a permanent stimulus where ordinary US consumer is provided regular checks similar to Basic Income Guarantee (BIG)would there be a possibility of persistent inflation led by wage inflation. An example of the same would be in the years of UPA-I & II in India where monetary stimulus in terms of NREGA and MSP spends led to significant cash in the hands of consumers leading to wage inflation and increase in demand for same set of goods.

US still is not in the state and given antipathy towards anything that can be constituted as socialistic policies, it is very hard for US to initiate something on the line of BIG even with a democratic president, congress and senate. Given that the Biden presidency is looking at an infrastructure stimulus which in the longer term should be deflationary given the structural impact on supply, inflation in the US economy in the near term (2021–25s) is very less likely.

PS: I do agree that the inflation in the asset classes is not sustainable, but the Fed has caught itself in a corner. There will be a day of reckoning where it will have to stop QE and raise interest rates which throw the markets into chaos. The trick will be do it in a way that will not lead to a recession in the real economy.